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The Promise of Index Insurance

Index-based insurance is an innovative financial product, which has been introduced in recent years in countries as diverse as India, Mongolia, Malawi and Thailand. It allows individual smallholder farmers to hedge against agricultural production risk, such as drought or flood. The product pays out in events that are triggered by a publicly observable index, such as rainfall recorded on a local rain gauge. Advocates argue that index insurance is transparent and inexpensive to administer, enables quick payouts, and minimizes moral hazard and adverse selection problems associated with other risk-coping mechanisms and insurance programs.

Figure 1 presents an example of a policy against deficient rainfall. As one can see, upper and lower rainfall thresholds are specified. The policy pays zero if accumulated rainfall exceeds the upper threshold; otherwise, the policy pays a fixed amount for each millimeter of shortfall relative to the upper threshold, until the lower threshold is reached. If rainfall falls below the lower threshold, the policy pays a fixed (higher) payout.

As mentioned in President Zoellick’s 10-Point Plan, this financial innovation holds significant promise for rural households. Shocks to agricultural income, such as a drought-induced harvest failure, generate fluctuations in household consumption that are not perfectly insured; at the extreme they may lead to famine or death. The evidence suggests that households in developing countries are only partially insured against income shocks. Moreover, weather events tend to affect all households in a local geographic area, making other risk-sharing mechanisms, such as inter-household transfers and local credit and asset markets, less effective at reducing the impact of the shock.

Index-based insurance policies can be sold as a stand alone product or linked with credit.A series of papers [India-WBER, barriers] study a stand alone rainfall insurance product offered in recent years to smallholder farmers in the Andhra Pradesh region of southern India. Another paper [Malawi - JDE] studies the demand for insurance when it is bundled together with a loan.

These policies are typically sold without subsidies. The premium is calculated as the sum of the expected payouts, a share of its standard deviation and of the maximum sum insured in a year (loading factor), plus a percent administrative charge and government service tax.

A basic research question for the study of these micro-insurance products is estimating the determinants of household insurance take-up, and identifying the factors which prevent the remaining households from participating.

Evidence from India suggests credit constraints and low household income appear to be an impediment to purchasing insurance. Households with less land and less wealth, as well as those households which report being credit constrained, are less likely to participate in insurance. Insurance participation increases with wealth. Second, a variety of results together suggests that limited familiarity with the insurance product plays a key role in participation decisions. Take-up rates are higher among existing customers of the insurance vendor. Risk-averse households are less likely to purchase insurance, but only if they are unfamiliar with insurance or with the insurance provider. Respondents who likely have lower cognitive costs of understanding and experimenting with insurance, such as young farmers and self-identified progressive farmers, are more likely to purchase the product. And a significant fraction of households cite advice from other farmers and limited understanding of the product as important determ12:17 PM 09/17/2008inants of participation decisions.

The finding of the significance of credit constraints has practical implications for insurance contract design. One is that insurance payouts should be made as promptly as possible after rainfall is measured and verified. A second implication is that it may be advantageous to combine credit with insurance, as has been done in Malawi. The results there suggest that the lender is already providing a lot of implicit insurance through limited liability. In other words, in case of a drought, the lender will forgive the loan without future negative consequences. In this context, then, clients are not very interested in additional insurance.

Thus, there are barriers to the demand for these insurance products which have not yet succeeded in proportionately reaching the most vulnerable households, which presumably would benefit the most.

In the case of Malawi, the focus has been on the client’s demand for insurance, not the lender’s. When one takes into account the lender’s perspective, a much clearer picture emerges. For the lender, weather insurance is an attractive way to mitigate default risk and thus, it can become an effective risk management tool with the potential of increasing access to credit in agriculture at lower prices.